Prof. Jayanth R. Varma's Financial Markets Blog

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Taxation of securities

I wrote a column in the Financial Express today about the taxation of securities.

Over a period of time, several distortions have crept into the taxation of investment income in India. The budget later this month provides an opportunity to correct some of these without waiting for the sweeping reforms proposed in the direct taxes code. I would highlight the non-taxation of capital gains on equities, the securities transaction tax (STT) and the taxation of foreign institutional investors.

In the current system, the capital gain on sale of equity shares is not taxable provided the sale takes place on an exchange. Of course, there is STT, but the STT rate is a tiny fraction of the rate that applies to normal capital gains.

The taxation of capital gains is itself very low compared to the taxation of normal income. There is no justification for taxing capital gains at a lower rate than, say, salary income. After all, a substantial part of the salary of skilled workers is a return on the investment in human capital that led to the development of their skills.

Why should returns on human capital be taxed at normal rates and returns on financial capital at concessional rates? Even within financial assets, why should, say, interest income be taxed at normal rates while capital gains are taxed at concessional rates?

The discussion paper on the direct taxes code argues that a concessional rate is warranted because the cumulative capital gains of several years are brought to tax in one year and this would push the tax rate to a higher slab. This factor is in many cases overwhelmed by the huge benefit that arises from deferment of tax.

For example, consider an asset bought for Rs 100 that appreciates at the rate of 10% per annum for 20 years so that it fetches Rs 673 when it is sold. A 30% tax on the capital gain of Rs 573 amounts to Rs 172 and the owner is left with Rs 501 after tax. By contrast, if the owner had received interest at 10% every year and paid taxes at a lower slab of 20% each year, the post-tax return would have been 8%. Compounding 8% over 20 years would leave the investor with only Rs 466. In other words, 20% tax paid each year is a stiffer drag on returns than a 30% tax that can be deferred till the time of sale.

In practice, of course, indexation and the periodic re-basing of the original cost of the asset makes the tax burden on capital gains even lighter. There is no economic or moral justification for subsidising the wealthy in this manner.

Ideally, tax rates should be calibrated in such a manner that equal pre-tax rates of return translate into equal post-tax rates of return regardless of the form in which that return is earned. This might be too much to ask for, but a near zero tax rate for capital gains earned on equity shares makes a mockery of the tax system in the country and should be redressed as soon as possible.

The STT is by its very nature a bad tax because it is unrelated to whether the transaction resulted in a profit or a loss. The real reason for the STT was to make the process of tax collection easier. In this sense, the STT is best regarded as a form of the nefarious system of tax farming that is shunned by modern nation states.

Some attempts are being made to justify the STT as a form of Tobin tax on financial transactions. Without entering into a debate on whether a Tobin tax is good or bad, it should be pointed out that the STT is not a Tobin tax. This is evident from the fact that delivery-based transactions attract STT at rates several times higher than on the presumably more speculative non-delivery-based transactions. The rate on delivery-based transactions is far higher than any reasonable Tobin tax.

A final argument for STT in lieu of capital gains is that foreigners pay lower taxes in India. Many other countries tax foreign portfolio investors at low rates. Indian investors can make portfolio investments in the US (within the limit of $200,000 per annum permitted by RBI). They would not pay income taxes in the US on their income from this investment and would pay only Indian taxes.

There is symmetry here to the US portfolio investor paying taxes in the US but not in India. The only difference is that the foreign investor into India has to come through Mauritius while the portfolio investor into the US can go in directly.

We should also exempt foreign portfolio investors from taxation without forcing them to come via Mauritius. The real problem with the Mauritius loophole is that it allows even non-portfolio investors to avoid Indian taxes, but that is a different topic altogether.

Posted at 2:11 pm IST on Fri, 19 Feb 2010         permanent link